A Proxy Asset is a new kind of security that is designed to make effectively tradable existing broad categories of illiquid assets or claims on income flows, assets or claims that are individually difficult or impossible to buy, hold, or sell directly. The Proxy Asset is designed to have a traded market price that reflects the true liquid-market value of the illiquid assets or claims. For example, Proxy Assets can be created that allow people to make investments in local real estate in a given city, and allowing owners of local real estate to hedge their exposure to real estate risk in that city, and also to allow them to see in the Proxy Asset share price an indicator of real estate prices in the city. For another example, Proxy Assets can be created to allow people to invest in claims today on shares of the flow of national income over future years of some country, or to allow people to hedge their own income risk, and also to see a market price of such a claim as never before. Thus, as used herein, the term Proxy Asset pertains to illiquid assets and to claims on income sources, such as human labor or human capital. For still other examples of illiquid assets that may be the basis of Proxy Assets, we mention privately held or infrequently traded corporate stocks, infrequently traded bonds, ships and aircraft, rare coins, precious gemstones, masterpiece paintings, livestock, and thoroughbreds. These assets, like real estate, are highly illiquid, and are difficult or impossible to hedge using traditional hedging mechanisms.
A Proxy Asset Data Processor is employed as part of a Proxy Asset Management System, and is designed for creating, distributing, managing, and maintaining the Proxy Assets. The new data processor makes possible this fundamentally new kind of asset by defining and managing the dividend flow of these assets, guaranteeing payment of the defined dividend by management of underlying cash-value accounts, and also facilitating trade, issuance and redemption of such Proxy Assets and thereby assuring certain adding-up constraints for market prices.
The Proxy Assets are configured to simplify their use, and understanding by investors; to parallel familiar existing assets in appearance and in terms of the kinds of contingencies and activities that the investors become involved with, and to offer the same feeling of financial soundness. The Proxy Asset Data Processor is designed to reinforce and confirm these impressions among investors, by facilitating the basic functions necessary for the Proxy Asset's essential equivalence with other assets.
Making otherwise illiquid assets liquid is extremely important. With illiquid markets, investors may be stuck with an inordinately risky exposure to some illiquid assets and at the same time unable to diversify their portfolio into other illiquid assets. For example, in the market for single family homes, people may be excessively exposed to single family home price risk in their own city, unable to hedge this risk by shorting their city, and unable to invest in single family homes in other cities.
Laws and regulations regarding securities trading are designed to make a clear distinction between securities and derivatives (such as futures and options), and between securities and short sales. Institutions that hold securities as part of their portfolios may be restricted by charter, pronouncement, or regulation from dealing freely in derivatives or from making short sales. These restrictions are designed to guarantee against certain abuses, such as taking excessively speculative positions. Individual investors, fearful of getting into an unexpectedly leveraged position or of being exposed to large or unlimited losses in certain circumstances, may have simple personal rules of thumb so that they will not buy unusual investment instruments. Our Proxy Assets are designed to resemble existing well-known types of securities, like ordinary stocks, so that these restrictions may have their intended effect.
That Proxy Assets resemble familiar securities may also have certain psychological benefits. First, people are somewhat afraid of investing in exotic derivatives because they have the feeling that the structure of the contract is too complicated and abstract, unlike the common law concept of property that has been fundamental to human society since prehistoric times. People tend to feel insecure about an investment whose payoff is determined by a complex contract or mathematical formula in contrast to a traded market price. Second, there are familiar institutions and practices associated with ownership of securities that are not duplicated with most derivatives. For example, the simple notion that an asset has both an enduring capital value and also generates an income at regular intervals, and that one may have a rule of thumb allowing one to consume the income but not the capital value itself. Third, many derivatives can involve margin calls to which investors can react very negatively because they force investors to focus on their losses from individual portions of their portfolio, even when their overall portfolio is doing well. Thus, for example, investors who hedge against losses in holdings of an asset by taking a short positions in the futures markets can be very upset by the repeated margin calls that would be the consequence of such hedging should prices increase. They tend to feel upset by the margin calls even though their losses in the futures market are compensated since the value of the portfolio of other assets is increasing, since the former is made more psychologically salient by the need to take action. An individual who hedges risk by taking a position in a Proxy Asset whose price moves opposite that of the asset hedged will not be confronted by margin calls, can just forget about the portfolio, and thus may be psychologically in a frame of mind that better promotes hedging.
There have been over time, many different types of investment vehicles. Investment Trusts (REITs) which were designed by an act of the U.S. Congress in 1960 to allow large numbers of investors in real estate, are no more than tax-exempt portfolios of existing readily-made real estate investments. The real estate that they cover is limited to already readily investable classes, excluding for example owner-occupied homes. REITs are not flexible and thus cannot meet current hedging and investment needs.
There are a number of mortgage, reverse mortgage, or sale-of-remainder methods that individual homeowners can use to reduce risk to them due to price fluctuations in their home. Shared appreciation mortgages have a long (though limited) history. A variation on this is the housing limited partnership. Reverse mortgages are contracts in which a homeowner is able to obtain a lifetime annuity from the value of his or her home; these reverse mortgages may pass some of the price risk to the mortgage lender. Sale of remainder refers to a contract in which the homeowner may sell a share in the house to another party with a contract to remain living in the house.
Home equity insurance, discussed in Robert J. Shiller and Allan N. Weiss, "Home Equity Insurance," National Bureau of Economic Research Working Paper 1994, forthcoming, Journal of Real Estate Finance and Economics, incorporated herein by reference, is an insurance contract on an individual home that pays out if the price index for the region should fall sufficiently.
In 1994, Barclays de Zoete Wedd (BZW) started Property Index Certificates (PICs). These are bonds, with maturities of two, three, four, and five years, whose principal at maturity is tied to a commercial real estate price index. BZW owns companies like Canary Wharf and Imry as a result of bad property loans, and has issued the PICs as a way to insulate itself from further moves in commercial real estate prices. In November 1996, BZW also created what are essentially UK commercial real estate index settled futures, although there is no clearing house and BZW is always one side of the contract. An industry-wide group led by AMP Asset Management (the fund management component of Australia Mutual Provident), has been scheduled to start true index-settled UK commercial real estate futures markets in 1997.
There have been for some time ordinary puts and calls that are settled on indices, such as the Standard and Poor's Index Options. There have been certain swap arrangements that investment banks make between themselves and counter parties. Banks may make many such swap arrangements in such a way that the swaps cancel out, and the bank itself is bearing no risk.
The Standard and Poor Depositary Receipts (SPDRs, or, commonly, spiders) were created at the American Stock Exchange in 1993. Each SPDR is like a security, which is traded on the stock exchange, and behind it is an underlying basket of assets, representing the stocks used to compute the Standard and Poor Composite stock price average. Redemption and issuance rules enforce market price correspondence with the market price of the underlying portfolio. The assets held are the actual stocks themselves. Still, the SPDRs are used to create an asset that is like a stock and to insure that the market price corresponds at all times to the value of the basket of stocks. The "superunits" and the "supershares" created at the AMEX somewhat earlier also shared this property.
Certain computerized trading systems, such as that used at the Iowa Experimental Markets at the University of Iowa have been used in the past. For example, in their presidential election trading system, a security is created for every presidential candidate, and it pays $1 if that person is elected president. Since only one person can be elected president, the trading system can automatically create new securities whenever buy orders for all presidential candidates come in with combined offer prices equal to $1.
See also, "A Goal-Directed Financial Asset Management System" invented by Robert R. Champion and Basil R. Twist Jr., awarded U.S. Pat. No. 5,126,936 on Jun. 30, 1992, and a System for the Operation of a Financial Account invented by Charles A. Atkins and Amelia Island, and awarded U.S. Pat. No. 4,953,085 on Aug. 28, 1990.
Accordingly, none of the prior art satisfies the objectives of the present invention, and none shows the basic features of the invention as described hereinbelow. More background information can be found in the following references, the contents of which are incorporated by reference.
Karl E. Case, Robert J. Shiller, and Allan N. Weiss, "Index-Based Futures and Options Trading in Real Estate," with Karl E. Case and Allan N. Weiss, Journal of Portfolio Management, Winter 1993. PA1 Robert J. Shiller, Macro Markets: Creating Institutions for Managing Society's Largest Economic Risks, Oxford University Press, Oxford England, (Clarendon Series) 1993. PA1 Robert J. Shiller and Allan N. Weiss, "Home Equity Insurance," National Bureau of Economics Working Paper, 1994.